A Worrying Set Of Signals

Positioning for a US Recession.

There is presently a bull market in complacency. There are very few alarm bells going off anywhere; and frankly, in reaction to my own personal complacency, I have my antenna up for whatever it is I might be missing that would indicate an approaching recession.

It was very easy to call the last two recessions well in advance because we had inverted yield curves. In the US at least, that phenomenon has a perfect track record of predicting recessions. The problem now is that, with the Federal Reserve holding the short end of the curve at the zero bound, there is no way we can get an inverted yield curve, come hell or high water. For the record, inverted yield curves do not cause recessions, they simply indicate that something is seriously out of whack with the economy. Typically, a recession shows up three to four quarters later.

I know from my correspondence and conversations that I am not the only one who is concerned with the general complacency in the markets. But then, we’ve had this “bull market in complacency” for two years and things have generally improved, albeit at a slower pace in the current quarter.

With that background in mind, the generally bullish team at GaveKal has published two short essays with a rather negative, if not ominous, tone. Given that we are entering the month of October, known for market turbulence, I thought I would make these essays this week’s Outside the Box. One is from Pierre Gave, and the other is from Charles Gave. It is not terribly surprising to me that Charles can get bearish, but Pierre is usually a rather optimistic person, as is the rest of the team.

I was in Toronto for two back-to-back speeches before rushing back home this morning. I hope you’re having a great week. So now, remove sharp objects from your vicinity and peruse this week’s Outside the Box.

Each day, you get the three tech news stories with the biggest potential impact.

A Worrying Set Of Signals

By Pierre Gave
Sept. 28, 2015

Regular readers will know that we keep a battery of indicators to gauge, among other things, economic activity, inflationary pressure, risk appetite and asset valuations. Most of the time this dashboard offers mixed messages, which is not hugely helpful to the investment process. Yet from time to time, the data pack points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.

Growth: The three main indices of global growth have fallen into negative territory: (i) the Q-indicator (a diffusion index of leading indicators), (ii) our diffusion index of OECD leading indicators, and (iii) our index of economically-sensitive market prices. Also Charles’s US recession indicator is sitting right on a key threshold (see charts for all these indicators in the web version).

Inflation: Our main P-indicator is at a maximum negative with the diffusion index of US CPI components seemingly in the process of rolling-over; this puts it in negative territory for the first time this year.

Risk appetite: The Gavekal velocity indicator is negative which is not surprising given weak market sentiment in recent weeks. What worries us more is the widening of interest rate spreads—at the long-end of the curve, the spread between US corporate bonds rated Baa and treasuries is at its widest since 2009; at the short-end, the TED spread is back at levels seen at the height of the eurozone crisis in 2012, while the Libor-OIS spread is at a post-2008 high. Moreover, all momentum indicators for the main equity markets are at maximum negative, which has not been seen since the 2013 “taper tantrum”.

These weak readings are especially concerning, as in recent years, it has been the second half of the year when both the market and growth has picked up. We see three main explanations for these ill tidings:

1) Bottoming out: If our indicators are all near a maximum negative, surely the bottom must be in view? The contrarian in us wants to believe that a sentiment shift is around the corner. After all, most risk-assets are oversold and markets would be cheered by confirmation that the US economy remains on track, China is not hitting the wall and the renminbi devaluation was a one-off move. If this occurs, then a strong counter-trend rally should ramp up in time for Christmas.

2) Traditional indicators becoming irrelevant: Perhaps we should no longer pay much attention to fundamental indicators. After all, most are geared towards an industrial economy rather than the modern service sector, which has become the main growth driver. In the US, industrial production represents less than 10% of output, while in China, the investment slowdown is structural in nature. The funny thing is that employment numbers everywhere seem to be coming in better than expected. In this view of things, either major economies are experiencing a huge drop in labor productivity, or our indicators need a major refresh (see Long Live US Productivity!).

3) Central banks out of ammunition: The most worrying explanation for the simultaneous decline in our indicators is that air is gushing out of the monetary balloon. After more than six years of near zero interest rates, asset prices have seen huge rises, but investment in productive assets remains scarce. Instead, leverage has run up across the globe. According to the Bank for International Settlements’ recently released quarterly review, developed economies have seen total debt (state and private) rise to 265% of GDP, compared to 229% in 2007. In emerging economies, that ratio is 167% of GDP, compared to 117% in 2007 (over the period China’s debt has risen from 153 to 235% of GDP). The problem with such big debt piles is that it is hard to raise interest rates without derailing growth. Perhaps it is not surprising that in recent weeks the Federal Reserve has backed away from hiking rates, the European Central Bank has recommitted itself to easing and central banks in both Norway and Taiwan made surprise rate cuts. But if rates cannot be raised after six-years of rising asset prices and normalizing growth, when is a good time? And if central banks are prevented from reloading their ammunition, what will they deploy the next time the world economy hits the skids?

Hence we have two benign interpretations and one depressing one. Being optimists at heart, we want to believe that a combination of the first two options will play out. If so, then investors should be positioned for a counter-trend rally, at least in the short-term. Yet we are unsettled by the market’s muted response to the Fed’s dovish message. That would indicate that investors are leaning towards the third option. Hence, we prefer to stay protected and for now are not making a bold grab for falling knifes. At the very least, we seek more confirmation on the direction of travel.

Positioning For A US Recession

By Charles Gave
September 29, 2015

Since the end of last year I have been worried about an “unexpected” slowdown, or even recession, in the world’s developed economies (see Towards An OECD Recession In 2015). In order to monitor the situation on a daily basis, I built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped “traditional” cyclical economic data of any real meaning (see Gauging The Chances Of A US Recession).

Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below – 5 then it is time to get worried – on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long-dated US bonds as a hedge. This is certainly not a time to buy equities on dips.

Today my indicator reads – 5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. Pierre explored this discrepancy in yesterday’s Daily (see A Worrying Set Of Signals), so my point today is to offer specific portfolio construction advice in the event of a developed market contraction. My assumption in this note is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.

During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart below shows the S&P 500 divided by the price of a 30-year zero-coupon treasury.

A few results are immediately clear:

Equities should be owned when the indicator is positive.

Bonds should be held when the indicator is negative.

The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favorable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet. Today the ratio between the S&P 500 and long-dated US zeros stands at 75. This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30-year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between. Notwithstanding the continued relative strength of headline US economic data, I would note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from my recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.

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5 comments for “A Worrying Set Of Signals”

Petunia

Oct 4, 2015 at 11:20 am

Middle class America is descending into poverty. Most are already one paycheck away from disaster. Investing is an aspirational activity and working people have nothing to be aspirational about, therefore the prospects for investing are not bright. The market is overpriced by every metric if you take this into account.

As far as the fed raising rates goes, they have always lead from behind, as the brakes, not the propeller. Nothing is stopping the banks from offering higher rates except greed. Credit cards and consumer loans all charge outrageous rates. Corporations could issue higher coupons to increase demand, but why bother, the money is not for anything productive, so they withdraw and wait. It is all a race to the bottom and we are getting there fast.

rich black

Oct 4, 2015 at 1:48 pm

“It is all a race to the bottom and we are getting there fast.”

There is no such race to the bottom in West LA, Austin, Denver, SF or West Palo Alto, but most of Main Street America has been bumping along the bottom since 2008. Without Fed funny money fueling stock buybacks, the stock market would be pond scum.

Petunia

Oct 4, 2015 at 2:10 pm

As far as I know the LA economy is fueled by foreign real estate investment, which may dry up at any time. Texas is already crashing with both oil prices and military spending down. Denver is fueled by the new drug trade which might expand to other states. A Silicon Valley salary, as spectacular as it might be in another area, barely amounts to a living wage there.

When you add up the growth areas you land up with an economy based on foreign real estate investments and the drug trade. If this is the growth engine they plan to depend on, they should say so, so we can all get on with the plan.

rich black

Oct 4, 2015 at 4:11 pm

“As far as I know the LA economy is fueled by foreign real estate investment, which may dry up at any time.”

There’s far more to LA’s boom than foreign buyers. Downtown LA is being transformed. Rodeo Drive may have been taken over by the Chinese and the Russians, but new downtown luxury apartment highrises (some financed with foreign money) can’t be built fast enough. The locals are reclaiming downtown LA. And in West LA, houses are being knocked down and ultramodern concrete and glass, retro styled mid-century homes are going up, on small lots. They are bringing $3 million or so, and selling well.

“Texas is already crashing with both oil prices and military spending down.”

I didn’t mention Texas, I mentioned Austin. Austin is not so dependent upon oil and gas. It is a hip, highly desirable town with one of the most heavily endowed universities in the country. It was trending up before the fracking boom. Austin is to Midland-Odessa as NYC is to Buffalo. Cities in the same state, but far different markets.

“Denver is fueled by the new drug trade which might expand to other states.”

That’s not what fueled Denver. The development of the high speed line fueled Denver, along with amazing gentrification of urban neighborhoods. This happened well before pot was legalized there. Houses in the Highlands, that I could have bought all day for $60, 000 12 years ago, are going for half a million. It’s been white flight in reverse. They’re moving into Denver, not moving out of it.

“A Silicon Valley salary, as spectacular as it might be in another area, barely amounts to a living wage there.”

I know only too well. In a couple of months, my oldest daughter is going to coding school in SF. She’ll be living on people’s couches. However, I can’t remember when the Silicon Valley was anything other than crazy money. My sister was having to pay big money when she was going to Stanford for her Masters, and that was over 30 years ago.

In my opinion, both Austin and Denver have become overpriced. Still, I sold my condo conversion penthouses in Denver in 2006, and now I feel like a fool for doing so. As far as Colorado booming because of grass, I suggest you take a look at Pueblo and Walsenberg. If they are booming, I’d hate to see what a bust looks like.

Peepot

Oct 4, 2015 at 11:34 pm

Here’s something else from John the clown who uses a photo for his newsletter than is at least twenty years out of date…. talk about a wanker!

“I think it’s pretty much a given that we’re in for a cyclical bear market in the coming quarters. The question is, will it be 1998 or 2001/2007? Will the recovery look V-shaped, or will it drag out? Remember, there is always a recovery. But at the same time, there is always a recession out in front of us; and that fact of life is what makes for long and difficult recoveries, not to mention very deep bear markets.”

There’s always a recovery? Not this time John….

THE PERFECT STORM (see p. 58 onwards)

The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy.

But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.